Derivatives Alerter - Section 2(a)(iii): Time for a change?

Regular recipients of our alerters will know Section 2(a)(iii) of the ISDA Master Agreements is a bit of a pet subject for us. Indeed, we have been talking about it ever since the Enron v TXU case in 2003.

ISDA have now picked up the baton under some pressure from the UK Treasury, among others, and in the face of some slightly unexpected recent court decisions. Here is a link to the ISDA consultation paper, comments on which are due on 31 May 2011.

We thought it would be useful for our clients and contacts to be aware of the proposals and a couple of issues to consider which might not occur on a read of the consultation paper.

We have for some time been proponents of a Section 2(a)(iii) waiting period and so we welcome the fact that is the key principle of the ISDA proposal. However, some aspects of the proposal warrant further consideration and, we suggest, need to be developed further.

The waiting period. This is proposed to be 90 or 180 days. The paper mentions that shorter periods were considered, and our experience of talking to clients is that a much shorter period of 30 days / 20 business days is probably more appropriate. This is, of course, a commercial issue ultimately. More importantly, it should be noted that in the ISDA proposal the waiting period does not start on the date the non-defaulting party becomes aware of the Event of Default (or Potential Event of Default) affecting the other party, but instead on the date on which the non-defaulting party withholds its first payment or delivery. This gives rise to a waiting period which will be different from transaction to transaction and and that might never apply to certain product types. Take a CDS for example - where X buys protection from Y, X suffers an Event of Default and ceases to pay its premium. Y continues to accrue an accumulating increased claim against X for unpaid premium and yet has no intention of ever settling if a Credit Event occurs with respect to the reference entity. The ISDA proposal would not protect X here. In fact, the only way X can be protected in this example is to provide for an automatic waiver of an Event of Default if no Early Termination Date is designated within a set period of being entitled to do so. This is a true "put up or shut up" provision. There are arguments for an against each approach.

Potential Event of Default. Here there is the question of whether the time period would run twice, once for the Potential Event of Default and then again for the Event of Default. This is probably just further clarity that is required. However there remains the related issue of whether or not a person affected by a Potential Event of Default ought to be able to "elevate" this to an actual Event of Default in order to trigger the "put up or shut up" consequence. On this issue, we would say that there should be no time limit on the application of Section 2(a)(iii) for Potential Events of Default as (a) these are rarely, if ever, indefinite and (b) if the affected party can elevate it to an Event of Default, this gets to a result which we would say is more commercially appropriate than the ISDA proposal.